Tweaking the Target Portfolio

I've decided to slightly tweak the target portfolio weights to reflect a larger allocation to hedge funds. The top level allocation is 59% to equity and 41% to everything else. Then there is 10% to private equity (split between venture and buyout) and 49% to public equity. Within that 25% to long-only and 24% to hedge funds (was 21.5%) (also split 50/50 to Australian focused and foreign focused funds). And within the long-only 13% to Australia and 12% to the rest of the world. Within Australian 9% to large cap and 4% to small cap and within foreign 5% to the US and 7% to other countries. Within the "everything else category", 10% to gold, 10% to bonds, 10% to real estate, 5% to art, 5% to futures, and 1% to cash and everything else. So:

9% Australian large cap

4% Australian small cap

5% US stocks

7% ROW stocks

12% Australian focused hedge funds

12% Foreign focused hedge funds

5% Venture capital

5% Buyout PE

10% Gold

10% Real estate etc.

10% Bonds

5% Art

5% Futures

1% Cash etc.

Overall the whole portfolio is levered by about 20% (assets are 120% of equity). This 20% is roughly the value of our house, which isn't included in the above. We also try to maintain a 50:50 allocation to Australian Dollar exposure vs. foreign currency exposure. My job is mainly to choose funds and a couple of stocks and do a little trading in part of the futures allocation.

We are still overweight hedge funds after this change.

Incentives for Charitable Giving in Australia

As there is no estate or inheritance tax in Australia, I think it makes much more sense to give money to charity while you are alive rather than in your will. If I give money in my will, my children will have less but no tax benefit from giving money. If I give while I am alive then I can claim a tax deduction. Or am I wrong?

P.S. 6 February

I thought of an alternative approach. You can write in your will that your children need to make contributions to charity from the money they receive. That way they can take tax deductions instead. The advantage of this is that if you are unsure if you will run out of money in retirement you can direct your children to make donations if you didn't run out of money. The downside is that they may not follow your directions. Maybe there is some trust structure that enforces this. Also, you don't get to see the benefits of your donations.

Started SMSF Process

I made it my new year resolution to finally set up an SMSF. This is the next step in our financial restructuring process. The final step will be estate planning. The idea is to put relatively high tax investments into the SMSF. Also, we will put direct holdings of US stocks into the fund, so that they aren't part of our estate. Yes, there is a tax treaty between Australia and the US, which would mean that we wouldn't pay any tax at the moment. But it is likely that the threshold for inheritance tax in the US will be reduced under the Democrats and there is still paperwork to do.

I have now started the process with SuperGuardian who seem to provide a lot of service with a lot of flexibility and have very good recommendations. All I've done so far is send in the client engagement form. The decisions I made so far are to use a corporate trustee and to use a Macquarie CMA as the fund's bank account. Apparently, one third of SMSFs use a Macquarie CMA and SuperGuardian's representative said a lot of their clients do too. A corporate trustee is a little more complicated and expensive in the short run, but seems more sensible in the long run. An SMSF with only individual trustees must have at least two trustees, while the corporate trustee can have a single director. As I am 11 years older than Moominmama, it's likely that she will end up being the only trustee/director unless we bring our children into the fund, or she involves at outside person as an additional trustee. She would also have to deal with all that and she currently isn't at all interested in any of this financial stuff.

Currency Exposures

 I took a more granular look at currency exposures:

So, actually I still have less than 50% exposure to the Australian Dollar. This probably still exaggerates Australian Dollar exposure. I couldn't find any information on the Australian vs. international bond exposure in any of four Australian balanced funds we are invested in. So I ascribed all their bond exposure to Australian bonds. I am always frustrated by the low level of disclosure regarding investments by most Australian funds in comparison to American funds.

Adjusting the Target Portfolio

Given the continued underperformance of managed futures, I think I am going to again lower my allocation to this asset class to 5% from 10%. I've never gotten above 5% in managed futures funds anyway. In place of this, I could raise the allocation to real estate to 15% or raise both real estate and gold to 12.5%. Or is there something else I should allocate capital to?

Investing During the Pandemic

Financial Samurai's blogpost got me wondering how much I had taken advantage of the decline in asset prices earlier this year to add to my investments. So, I put together a table of all my exchange traded investments that aren't bonds plus the APSEC fund I recently invested in.  Not included are bonds, other unlisted funds such as Winton Global Alpha,  Aura Venture Capital, our Colonial First State Funds, the Everest Fund that recently wound up, and all our superannuation funds. The idea is to capture where I have made deliberate rather than automatic investments. 

The table presents snapshots on 1 February, before the pandemic had effects in Western countries, and today. The number of shares held is self-explanatory. Investment is the net cash invested in that investment. So, making an investment increases the number and withdrawal reduces it, but dividends and distributions that aren't re-invested also reduce it. All the numbers are in Australian Dollars and so the numbers also declined for 3i, Boulder, China Fund, and Pershing as the Australian Dollar rose. Investment per share is the investment number divided by the number of shares.

In total, I added $334k to these investments over this period. Most of this money came from maturing bonds. There are a lot of different patterns though. I might have made a mistake in investing the most in funds that were trading at the biggest discount to net asset value rather than what turned out to be the strongest funds. I didn't invest anything in Hearts and Minds and not much in Regal. I got a lot of extra shares in Cadence and Tribeca, which is a bet that they'll do better in the future. I increased my Pengana investment mostly because I thought I needed to invest more in private equity and because the fund had been trading at a big premium to net asset value. It's partly a bet that the premium will come back.

In general though, I have been cautious investing during this period because I invested a lot in early 2008 after the initial fall in the market, only to lose big later in the year. 

March 2020 Report

This month the financial crisis following the COVID-19 pandemic intensified. Up to around the 20th of the month there was chaos in financial markets. Many bonds fell as much or more than stocks and gold fell too as everything was liquidated. Then there began to be some stability with gold and many corporate bonds rallying again. I am now thinking that Australia might come out of this better than countries like the US and so betting a bit on Australian recovery makes sense. I am only doing that though in terms of moving towards our long-run allocation. Not over-allocating to Australian assets yet.

I expect HSBC are now happy they didn't give us a mortgage. It's not worth chasing them any more I think. We are keeping our children out of daycare and school, though technically they are still open. There was some miscommunication about applying for the subsidy and only this weekend I completed the application. Now the government announced today that childcare will be free to parents during the pandemic. I was thinking about cancelling the service, but if it is free, of course I won't. It's not 100% clear yet whether it will be free.

I think I will keep paying for my 4 year old's private preschool as we are considering the school as a long term schooling option (it goes through to year 10). Also, we are receiving a government subsidy. It's unclear yet whether this pre-school qualifies for the free childcare deal. We want to have a school for him when this crisis hopefully ends later this year. He goes to that school 2 days a week and 2.5 days to the public preschool.

All stock markets fell sharply in response to the Coronavirus pandemic. The Australian Dollar fell from USD 0.6499 to USD 0.6115 and at one point reached USD 0.55. The MSCI World Index fell 13.44%, the S&P 500 12.35%, and the ASX 200 20.42%. All these are total returns including dividends. We lost 8.95% in Australian Dollar terms and 14.33% in US Dollar terms. This was the worst monthly investment return ever in terms of absolute Australian Dollars lost (AUD 319k). The target portfolio lost 5.05% in Australian Dollar terms and the HFRI hedge fund index is expected to lose 5.88% in US Dollar terms. So, we under-performed these benchmarks though did better than the ASX 200. The value of our house, which is not included in this investment return, increased. Well, the price of houses in our city went up. Updating the monthly AUD returns chart:

Here is a report on the performance of investments by asset class:

The returns reported here are in currency neutral terms. All asset classes lost money. Australian small cap stocks was the worst performer and gold the least bad. The biggest detractors from my overall return were bonds and hedge funds. These supposed diversifiers didn't work to mitigate losses in stocks. Hedge funds in general both lost from fund performance and from the fall in the price of listed closed end funds relative to their net asset value.

Things that worked well this month:

• Pershing Square Holdings - this hedge fund did perform as intended, with the share price rising. The manager Bill Ackman made a big bet on credit default swaps that hedged the losses in the stock portfolio. Subsequently, he has closed those positions and bought more stocks. I bought more shares in PSH, which are trading around 65% of NAV.
• Treasury futures - my bet on a steepening yield curve worked and I closed half the position. The remaining position has backtracked since then.
• China Fund - I bought back our position, which has since performed well.

What really didn't work:

• Regal Funds - this was our worst performing investment this month in dollar terms. It lost 45% for the month.
• The Unisuper and PSS(AP) superannuation funds were the next biggest losers in dollar terms. They lost 13% and 9%, respectively, which is about what would be expected given a 20% fall in the Australian stock market.
• Junkier bonds like Virgin Australia. The value of Virgin Australia bonds halved. It's not our only distressed bond at this point, but just the worst. I don't know what I was thinking, buying this in the first place.
• Domacom (DCL.AX) shares fell by 2/3.

There are plenty more losing investments... We moved a little towards from our new long-run asset allocation. The shares of gold, private equity, and rest of the world stocks rose most:

On a regular basis, we invest AUD 2k monthly in a set of managed funds, and there are also retirement contributions. Other moves this month:

• Washington Gaslight and Lexmark bonds matured, releasing USD 60k plus interest. We didn't buy any new corporate bonds, so our exposure fell.
• We bought AUD 104k by selling US Dollars.
• I bought 25k Pengana Private Equity (PE1.AX) shares after the rights issue was cancelled. My timing could have been better as the shares then dipped before rebounding.
• I bought back our position in the China Fund (CHN). I figured that China is now rebounding. So far, that was good timing.
• I bought 25k Cadence Capital shares (CDM.AX). This fund has been a disaster, but the shares were trading at the value of cash that the fund has per share. So far, a good move.
• I bought 10k Tribeca Global Resources (TGF.AX) shares. Another disastrous investment in the long run, but the new shares have risen since buying them.
• I bought 25k Bluesky Alternatives shares (BAF.AX). They were trading at about 50% of NAV. I expect some of the fund's investments will be written down, but not that much overall.
• I shifted USD 4k from the TIAA Real Estate Fund to the CREF Social Choice Fund.
• I shifted about AUD 36k from the CFS Conservative Fund to the CFS Diversified Fund that has a higher risk allocation.

Asset Allocation Since October 2018

Since October 2018 when we nominally received the inheritance, the total allocated to cash, futures, gold, and bonds has remained fairly constant at 50%. There have been big shifts into bonds and to a lesser degree gold and I have bought Australian Dollars and sold US Dollars. But on net I haven't deployed money into real estate, private equity, hedge funds, and shares. Again, there has been some change in the mix of those "risk assets". Some of my bonds have also turned out to be quite risky...

Now it is looking more and more likely that there will be a recession and opportunities to buy risk assets cheaper. Though, if I really knew that I would have sold a lot of risk assets or shorted the market. So, I don't really know. Mainly I'll be watching the yield curve. The long-run target allocation to all these risk assets is around 70% and 30% in gold, bonds, and futures.

I am planning to increase purchases of Australian Dollars from AUD 10k per week to maybe AUD 15k per week in the short term.

New Target Portfolio Allocation

Following up on my post on the best portfolios for Australia, this post will lay out the new target portfolio allocation. The basic idea is to reduce the allocation to managed futures from 25% in my previous target portfolio to 10%. This is because I plan to do little active trading going forward and futures funds have had lacklustre performance for several years. Maybe they will come back, but we should see them more as a potential hedge than as a main asset class at this point I think.

At the top level the portfolio is 60% in stocks and 40% in other assets. The other assets are allocated equally between bonds, futures, gold, and real estate. The stocks allocation is roughly equally divided between Australian and international stocks. 10% of the portfolio is allocated to private equity and 50% to public. Then the public allocation is divided between long only and hedge fund strategies. Within the long only Australian allocation, 1/3 is devoted to small cap stocks. The full allocation is:

10% Australian large cap
5% Australian small cap
12.5% International stocks
10.75% Australian oriented hedge funds
10.75% International oriented hedge funds
10% Private equity
10% Bonds
10% Real estate
10% Gold
10% Managed futures
1% Cash

We will also usually use some leverage or gearing. 1% in cash seems sufficient given the ability to borrow.

Pulling the Plug on Short-Term Trading

I've decided to stop short-term trading. In recent months it hasn't made any money, it takes up a lot of time, and it gives me a lot of anxiety. Even though I am doing systematic trading I find myself looking at the market a lot and worrying about my positions. I can't seem to stop it. And my current position sizes are quite small. After a sleepless night, I've had enough. I already cancelled my orders that were waiting to execute. I will keep the existing Bitcoin and palladium positions until they exit naturally

Going forward, I will need to think about our overall financial plan again. Trend following funds aren't doing well in recent years, so we won't want to allocate that much to them compared to the current target allocation to "futures". What should we invest in instead? Should I still plan to set up an SMSF? I delayed that while I waited to see if trading was going to be a big part of it.

I've been here a couple of times before.

Trading Update

Well, that didn't last long. In November's report I said I would raise the risk allocation to palladium and soybeans. I just got stopped out of palladium futures though the contract is ending the day more or less where it began. I actually made a little money on the trade, but I'm not willing to take so much risk. So, I'm going to go back to trading palladium CFDs with a smaller amount of risk. I'll cut soybeans back to USD 2,500 risk as well. Yesterday, Bitcoin had a double stop out. First the long position was closed for a loss and a short opened and then the short was stopped out intraday. After all that, the contract ended near where it started:

I'm seriously thinking again of giving up on trading. Yes, you can make money doing this and I am now disciplined enough to always do the trades the algorithm says to do. But in practice there is still quite a lot of anxiety and mood swings. If I keep trading so small that I only make say a thousand dollars a month at it, it's not really worth the hassle. But if I make it big enough to make a difference I will have too much anxiety. That's the dilemma at this point. So far this financial year I am just losing money. I've given back all of last month's profit in the first week of this month.

Mortgage Inversion Complete, What Next?

I completed the transfer of money into our brokerage accounts from the "mortgage inversion".  That completes a major step in our financial restructuring since the inheritance. We've completed the first two steps on this list. I am thinking of refinancing our mortgage to get a lower interest rate now I don't care about having an offset account with my main bank. But how to go about this? Should I go to a mortgage broker or just contact a bank, like HSBC, who are offering a low rate?

Mortgage Redrawn

Just enter the amount, press the button, and:

Now to transfer the money to investment. This is how I account for this re-structure:

Almost all our historical savings from wages etc ("current savings") have now been converted into housing equity and extra retirement contributions. Housing equity is now a few hundred dollars short of the value of the house as I left a small amount of the mortgage unpaid in order not to potentially trigger something undesirable by totally paying it off.

Mortgage Almost Paid Off

It won't be for long!

Trading and Mortgage Inversion Update

We switched from short one contract of Bitcoin to long two this morning, booking a USD 30 loss on the short trade. We are long two as the per contract risk is lower now. After four losing Bitcoin trades, hopefully this is a winning one...

I sold a lot of shares this morning and already was allowed to move some of the proceeds to our offset account. I also paid down AUD 100k of the mortgage and was surprised to see that I could redraw it immediately. I had thought I would need to wait to 4th November for the redraw balance to update. This means that I might be able to complete the inversion this week.

P.S.

So I paid off another AUD 300k later in the day. Am still waiting on a transfer of AUD 100k from my margin loan. When I get it I should be able to complete the "inversion".

Optimizing Trading Portfolios and Shifting to Return on Risk Metric

I started exploring testing portfolios of trading strategies. For this, I decided that in looking at return on capital where capital is the face value of a futures contract doesn't make much sense. It seems to make more sense to look at the return on money at risk. It makes the most sense to measure that in dollars as a share of a total risk budget. This then leads me to making the primary measure of return also to be in dollars. Here is an optimized portfolio of Bitcoin, oil, and palladium:

The portfolio has a total risk budget of USD 5,000. This is then allocated across the three markets with the resulting profit curves. The analysis assumes that you can trade fractional futures contracts. Oil and palladium help diversify Bitcoin and increase the information ratio. Using a zero benchmark and daily returns on risk the portfolio IR is 2.96 rising from 2.17 for Bitcoin alone.

Oil hasn't gone anywhere in the last year, but did well in 2018 when Bitcoin struggled. Going forward, I will test whether each new market I look at improves the portfolio IR or not.

This approach then also leads to computing the prices for continuous futures contracts additively rather than multiplicatively – so that differences in dollars are preserved -– and to focusing on a constant risk budget in dollars. It also allowed me to simplify the back-testing program quite a bit. In the following chart the blue line is the daily profit curve for trading one contract of Bitcoin futures:

The red curve is based on completed trades only. The green curve has a constant dollar risk equal to the average of the single contract. To be more realistic I have rounded the number of contracts to the nearest whole number, which could be zero. This keeps the strategy out of the market in late 2017 and early 2018, when the single contract strategy had a big drawdown. The constant risk strategy has a higher return and a smaller maximum drawdown than trading a single contract. So, this is the strategy I am adopting for Bitcoin going forward. This morning, we switched from one contract long to one contract short...

Planning the Mortgage Inversion

I first wrote about this four years ago. I realized today that I could actually pull this off next month. At this point, I have close to AUD 300k in our bank account (which is an offset account). The mortgage is AUD 490k. If I sell some shares, which are currently in the red, like Tribeca Global Resources, realizing capital losses and transfer some Australian dollars from Interactive Brokers I can reach half a million dollars in our bank account. The amount of cash that can be redrawn is only updated on the 4th of the month, so I will wait to a little later this month to sell the shares and transfer the cash and pay off almost all the mortgage. Then in early November I will redraw the cash and transfer it to our brokers. As the mortgage is in both our names, I will transfer the money 50/50 to accounts in each of our names. After that, almost all of our mortgage interest should be tax-deductible. Of course, I could just pay off the mortgage. But the interest rate for a home equity loan is higher than for an owner occupier mortgage and am happy to have debt at relatively low interest rates and invest it in stuff that hopefully will pay a higher return.

Variable Position Size, Again

I signed up for the Barchart Premier subscription. Among other things, this gives access to daily open, high, low, close etc. data for all US based futures contracts back to 2000. The data seems to be much more accurate than the various free sources. To start with, I downloaded all Bitcoin futures contracts data. I constructed a continuous series of prices going back to the beginning of trading in Bitcoin futures. I use proportional splicing that preserves percentage changes rather than absolute dollar changes. I also saved the actual futures prices for computing trading costs.

When we include the very volatile period right after the all time high in Bitcoin, the optimal trading strategy changes:

This graph shows the drawdown for a simple strategy that always buys the same number of contracts (in red) with a strategy that always has the same initial risk in percentage terms (in green). The latter targets a constant maximum 5% potential loss of the face value of the Bitcoin contracts before stopping out. The simple strategy soon finds itself 40% down at the end of January 2018. On the other hand, it manages to claw back that loss by late March... The constant risk strategy only loses a maximum of 15% over this period. On the other hand it performed worse during the string of 11 losing trades in a row in late 2018. But the Sharpe ratio for the constant risk strategy (2.45) is quite a lot higher than for the constant position size strategy (2.21). So, I am going to start varying position size, targeting a maximum loss of USD 5,000.

I will also start to revisit other markets to see where there is potential.

Previously, I found that there was a positive relationship between the initial risk of a trade and its return. When volatility is low moves seem to be more noise than signal. Looking at the relationship between initial risk and return, there is now a negative correlation between them, though it isn't statistically significant:

On the other hand,  the "lowest risk" trades here mostly had negative outcomes.
 

Trading Back on Track

After suffering some losses, it looks like I've got our trading back on track for the moment:

We were stopped out of Bitcoin this morning for a USD 16k gain at $11595 and $11600 in the August futures (3 contracts in total). As we are only doing long trades in Bitcoin, we don't have a Bitcoin position. This should be the impetus for subscribing to a data service and doing some backtesting of other markets...

We are also net positive in trading since 1996. However, the month is still not half-way over, so anything could happen by the end of the month.

Weekend Trading

Bitcoin is again rising over this weekend, so far. I set a stop buy order in my CFD trading account, which allows me to trade Bitcoin 24/7 for 7700 and it has triggered. Bitcoin is around 8000 at the moment. This long position hedges my short futures position. It allows me to have a stop on my position over the weekend when the futures market is closed. I would have been better off and less anxious if instead I had closed the futures position at the close of trading on Saturday morning Australian time. I think that is what I will do in future.